I worked in Japan for more than 12 years in the eighties and nineties, in Osaka, Nagoya and Tokyo with the U. S. State Department, Citibank and Merrill Lynch. After many more years in China in banking (Deutsche Bank and Ping An Bank) and consulting, I am back in Tokyo conducting the business of Yangtze Century Ltd. (Hong Kong/Shanghai) and producing this blog. E-mail me at smharnerco@yahoo.com.

Whither Japan Stocks: The Next Stage Of The Rally Will Not Be So Easy

Japan's high-tech maker Hitachi unveils the new mobility robot 'Ropits' (Robot for Personal Intelligent Transport System) in Tsukuba in Ibaraki prefecture on March 12, 2013. The one man mobility robot can pick-up and drop off a passenger autonomously, while the vehicle can be controled by a joystick controler in the cockpit. (Image credit: AFP/Getty Images via @daylife)

In the Trader-Asia column of this week’s Barron’s magazine, Assif Shameen breathlessly offers views on “What to Play NextNext in Japan’s Rally.” He begins by quoting the perennially exuberant–and sometimes right–Jesper Koll of JP Morgan Japan that “Japan is just entering a structural, multiyear bull market.”

If there are doubters that Japanese stocks are headed higher, maybe a lot higher, Shameen did not find any to quote in this article.

For most of the interviewees, the problem now is that the market’s quick adjustment to the radically new monetary and fiscal paradigm known as “Abenomics” and its immediate impact in weakening the Japanese yen, having returned the Nikkei 225 average to five year highs (Friday’s closing was 13,884), were so large that a respite is likely in the biggest gaining sectors–exporters, financials, and property.

It is hence time to look at companies in the domestic market and at the broader universe of manufacturers. A Macquarie Securities strategist in Tokyo sees substantial upside in tire-maker BridgestoneBridgestone (PINK:BRDCY) even after its stock (at 3680 yen) has doubled since November and trades at a very high 2.18 times book. “It didn’t matter which bank or broker or property firm you bought, you probably did very well,” avers the strategist. “With manufacturing, though, you would need to be very selective.”

True enough, to be sure, but not all that easy. Particularly, as pointed out in a Nihon Keizai Shimbun April 22 editorial, the correction from four years of an severly overvalued yen has removed a great handicap and burden from Japanese manufacturers, but at most it has created an environment is “neutral.”

No doubt the long period of yen overvaluation constituted an existential threat to much of Japan’s manufacturing sector. During the period, Toyota’s domestic operations were in loss. Many companies stopped investing domestically, opting instead to build new production capacity–and to transfer vital technology–abroad. The threat of “root and branch hollowing out”–symbolized by Nissan’s plans to move substantial capacity to North America–seems now reduced. But recovery of robust competitiveness in much of Japanese manufacturing lies ahead.

What does Japanese manufacturing need? According to the Nikkei, it is a vastly greater enthusiasm for change and, critically, acceptance of competition. In this respect, Japan’s participation in the Trans-Pacific Partnership (TPP) trade talks, as well as the start of the potentially more important Japan-China-Korea free trade area negotiations are hopeful steps.

Long term, such free trade agreements hold great promise for spurring increased competitiveness, including in sectors like agriculture, now largely zombified by decades of government protection.

But government initiatives–or government-private undertakings–are not the fundamental answer. Nor is the backward-looking tact of downsizing and restructuring alone. Rather, opines the Nikkei, to succeed now, Japanese companies need to challenge themselves to produce new products, to develop new markets, and to introduce new business models.

The Nikkei editorial holds up the examples of the U.S. GE, 3M3M, and–non-manufacturing–Tokyo Disneyland as relentless innovators, and as models that some Japanese companies have successfully emulated. One is IRIS OHYAMA a home products maker and on-line marketer whose corporate culture encourages trial and error and whose product line has been changing at a rate of 20% of items each year.

Needed are not only willingness to innovate and change, but speed of change, and focus on market opportunities. Nikkei points to the example of AppleApple and the Ipod–surely only one of dozens if not hundreds of instances–where the technology was present within a Japanese firm (in the Ipod case ToshibaToshiba)–but the firm had not taken the step to produce a marketable product.

While Apple has aggressively sought out and incorporated in its products technology from other firms or sources, Japanese companies have traditionally looked in-house for new technology and jealously guarded such development. Japanese companies must become more adept at integrating “open source” technologies, acquiring outside technology, and participating in “open innovation” technology development consortia.

For a hopeful example of adaptation to a changed market situation, the Nikkei points to Fuji Film (PINK:FUJIY). Since 2002 the company has been repositioning itself, developing basic materials for cosmetics and medical regeneration as it transitions away from film.

The editorial concludes with a call for improvement in another area of critical weaknesses of Japanese companies–not only manufacturers–in comparison with foreign rivals. This is in profitability.

For most Japanese CEOs, profitability may be the biggest challenge. The editorial proffers Terumo Medical (PINK:TRUMY) as a standout in profitability (and model of niche competition that eschews pursuit of size), but its net profit ratio of 10% is well below those of Abbott Labs or Johnson & Johnson.

The greatest weakness of Japan’s giant conglomerates, such as Hitachi Ltd. (PINK:HTHIY) is profitability. Hitachi considers itself, and is, a rival of General Electric. But GE’s net profit margin of 10.35% and cash flow margin of 15.60% are double those of Hitachi.

Relatively low profitability has not often prevented major Japanese firms from attracting capital, either debt or equity. So a low profit margin hurdle rate could be a competitive advantage for Japanese companies competing internationally, particularly if it were a choice.

But in most cases, low profits are a consequence of relatively high costs for virtually everything that still burden manufacturers in Japan. Carlos Ghosn had no trouble justifying plans to move Nissan manufacturing capacity to the U.S. and Mexico. It was all about costs, including the costs of electricity, made higher by the shutdown of all but two of Japan’s nuclear power plants and conversion to higher cost oil and LNG-fired plants.

Today Prime Minister Abe departs on a week long trip to Russia and the Middle East the main purpose and expected result of which is to help secure for Japanese interests ample future supplies of relatively cheap oil and gas. He is being accompanied by coterie of executives of Japan’s big industrial companies.

Such are the basics of what Japan’s manufacturers need as they struggle to compete and to offer the value now being optimistically–perhaps too optimistically–discounted in higher stock prices.

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Stephen Harner has hit on some crucial points that any real revival of Japan’s stagnation must be structural changes. 1. Low Profit Margins. Your bringing up Hitachi vs GE in comparison is telling. It is therefore an inherently less cost conscious corporate cultural that is the cause. Both have trans-national foot-prints. Perhaps this habit comes from the Bang & Olufsen model to push for such extreme quality that the cost exponentially escalates. Indeed Japanese quality was pushed extremely high matching Germans in both quality and price. But recently even Sony products seem to have slipped in quality and durability and yet prices are still high and their margins tight. Vertical integration seems to be another reason for high overall costs. Japan being a small nation, they had to select and focus their industrial development so that their giants looked to government leadership. In the 50s and 60s it was steel, cars, fabrics, electronics, and machine tools. Then robotics, fiber optics, computers were added. With government support, and therefore cushion, the drive was for excellence rather than cost. 2. Time Value of Innovations. There are very dazzling examples of Japanese innovative corporations at the leading edges of their sector. Japan needs another Professor Edward Deming to do for nimble technology what Deming did for quality circles. Quite likely due to the tremendous time-consciousness of the CPC, Japan’s premier sector of robotics has been slipping to the Chinese and Germans whose cooperation have increasingly dominated this field from low to the highest end. 3. Looking Mostly Internally for Innovation. That is a very perceptive point of Stephen’s. While Chinese firms have been voraciously seeking the best practices from the West, Japanese (and America) firms may have presumed that they are well ahead and that their points of focus are the best ones. Take the most dominating sector, Cameras, where Japanese concentrated upon excellent vertical integration. Chinese (Taiwanese) firms have come from the small areas of supplying the mini-camera and video systems for the cell phone. The tremendous volume of the cell phone growth has provided economy of scale for these firms so that the CMOS technology has taken over. With that low cost mass production of CMOS chips, they have had the money to R&D into small lenses and other innovations too. Coming from the small to the big, these Chinese vision companies have reached into the large format chips as well as other high end vision areas. Japanese firms have not lost the asymmetric marketing field. 4. Bureaucracy and Regulatory Restrictions. That I am sure Stephen knows about more than most of us who have not lived in Japan.

If Japan turns on a dime and fixes some of these structural retardants, there are many strengths they can extrapolate from. Several questions need to be answered and fixed: a. Will the Tokyo University elite wake up from the sinecure of their privileged position and join in taking down stifling constraint from which many of them rely on their power? b. Will zaibatsu giants radically change their corporate culture in cooperation with national revival needs and competitive needs? The large firms in the two lost decades have cored out their personnel so that a whole generation of young people are mostly part time workers. c. The Dark Forces. Merging with the [a] point, what spider’s web hold reactions to any major drive for change? These forces have traditional powers from centuries. d. Abe and his hawkish cabinet display an urge to turn hawkish that seems to have emerged so early upon their getting high poll numbers. They forget that so far the yes’s dip and stock market rise is a reaction on promises alone. Michael Harnett of Bank of America Merrill Lynch said that Abe stands for Asset Bubble Economics. John Mauldin said that Japan is a bug searching for a windshield. Axel Merk of Merk Fund California made the point that lowering currency is different from three decades ago. Advance Economies should not be competing on price. Christine Lagarde and Paul Krugman are the two large supporters of Abenomics. But they both assume that concurrently the third leg of “structural reforms” will kick in soon enough for Japan to take the first stage of euphoria into longer term sustained growth. That is a big assumption.